Chapter 5

Regression with a Single

Regressor: Hypothesis Tests
and Confidence Intervals
2
Regression with a Single Regressor:
Hypothesis Tests and Confidence Intervals
(SW Chapter 5)
Overview
- Now that we have the sampling distribution of OLS
estimator, we are ready to perform hypothesis tests about |
1

and to construct confidence intervals about |
1

- Also, we will cover some loose ends about regression:
- Regression when X

is binary (0/1)
- Heteroskedasticity and homoskedasticity (this is new)
- Efficiency of the OLS estimator (also new)
- Use of the t-statistic in hypothesis testing (new but not
surprising)

3
But first a big picture view
(and review)
We want to learn about the slope of the population regression
line, using data from a sample (so there is sampling uncertainty).
There are four steps towards this goal:
1. State precisely the population object of interest
2. Derive the sampling distribution of an estimator (this
requires certain assumptions)
3. Estimate the variance of the sampling distribution (which
the CLT tells us is all you need to know if n is large)
that is, finding the standard error (SE) of the estimator
using only the information in the sample at hand!
4. Use the estimator (
1

| ) to obtain a point estimate and, with

its SE, hypothesis tests, and confidence intervals.

4
Object of interest:
1
in,
Y
i
= |
0
+ |
1
X
i
+ u
i
, i = 1,, n
|
1
= AY/AX, for an autonomous change in X (causal effect)

The Least Squares Assumptions:
1. E(u|X = x) = 0.
2. (X
i
,Y
i
), i =1,,n, are i.i.d.
3. Large outliers are rare (E(X
4
) < , E(Y
4
) < .

The Sampling Distribution of
1

| :
Under the LSAs, for n large,
1

|

is approximately distributed,

1

| ~
2
1
4
,
v
X
N
n
o
|
o
| |
|
\ .
, where v
i
= (X
i

X
)u
i


5
Hypothesis Testing and the Standard
Error of (Section 5.1)
The objective is to test a hypothesis, like |
1
= 0, using data to
reach a tentative conclusion whether the (null) hypothesis is
correct or incorrect.
General setup
Null hypothesis and two-sided alternative:
H
0
: |
1
= |
1,0
vs. H
1
: |
1
= |
1,0

where |
1,0
is the hypothesized value under the null.

Null hypothesis and one-sided alternative:
H
0
: |
1
= |
1,0
vs. H
1
: |
1
< |
1,0


1

|
6
General approach: construct t-statistic, and compute p-value (or
compare to N(0,1) critical value)

- In general: t =
estimator - hypothesized value
standard error of the estimator


where the SE of the estimator is the square root of an
estimator of the variance of the estimator.
- For testing the mean of Y: t =
,0
/
Y
Y
Y
s n


- For testing |
1
, t =
1 1,0
1

( ) SE
| |
|

,
where SE(
1

| ) = the square root of an estimator of the variance

of the sampling distribution of
1

|

7
Formula for SE( )
1

|
Recall the expression for the variance of
1

| (large n):
var(
1

| ) =
2 2
var[( ) ]
( )
i x i
X
X u
n

o

=
2
4
v
X
n
o
o
, where v
i
= (X
i


X
)u
i
.
The estimator of the variance of
1

| replaces the unknown

population values of
2
v
o and
4
X
o by estimators constructed from
the data:
1
2

|
o =
2
2 2
1 estimator of
(estimator of )
v
X
n
o
o
=
2
1
2
2
1
1

1
2
1
( )
n
i
i
n
i
i
v
n
n
X X
n
=
=

where
i
v =
( )
i i
X X u .

8
1
2

|
o =
2
1
2
2
1
1

1
2
1
( )
n
i
i
n
i
i
v
n
n
X X
n
=
=

, where
i
v =
( )
i i
X X u .
SE(
1

| ) =
1
2

|
o = the standard error of
1

|

OK, this is a bit nasty, but:
- It is less complicated than it seems. The numerator estimates
var(v), the denominator estimates var(X).
- Why the degrees-of-freedom adjustment n 2? Because two
coefficients have been estimated (|
0
and |
1
).
- SE(
1

| ) is computed by regression software

- STATA has memorized this formula so you dont need to.

9
Summary: To test H
0
: |
1
= |
1,0
v.
H
1
: |
1
= |
1,0
,
- Construct the t-statistic
t =
1 1,0
1

( ) SE
| |
|

=
1
1 1,0
2

|
| |
o

- Reject at 5% significance level if |t| > 1.96
- The p-value is p = Pr[|t| > |t
act
|] = probability in tails of
normal outside |t
act
|; you reject at the 5% significance level if
the p-value is < 5%.
- This procedure relies on the large-n approximation; typically
n = 50 is large enough for the approximation to be excellent.

10
Example: Test Scores and STR,
California data
Estimated regression line: TestScore

= 698.9 2.28STR
Regression software reports the standard errors:

SE(
0

| ) = 10.4 SE(
1

| ) = 0.52

t-statistic testing |
1,0
= 0 =
1 1,0
1

( ) SE
| |
|

=
2.28 0
0.52

= 4.38
- The 1% 2-sided significance level is 2.58, so we reject the null
at the 1% significance level.
- Alternatively, we can compute the p-value

11
The p-value based on the large-n standard normal approximation
to the t-statistic is 0.00001 (10
5
)

12
Confidence Intervals for |
1

(Section 5.2)
Recall that a 95% confidence is, equivalently:
- The set of points that cannot be rejected at the 5%
significance level;
- A set-valued function of the data (an interval that is a
function of the data) that contains the true parameter value
95% of the time in repeated samples.

Because the t-statistic for |
1
is N(0,1) in large samples,
construction of a 95% confidence for |
1
is just like the case of
the sample mean:
95% confidence interval for |
1
= {
1

| 1.96 SE(
1

| )}

13
Confidence interval example: Test Scores and STR
Estimated regression line: TestScore

= 698.9 2.28STR

SE(
0

| ) = 10.4 SE(
1

| ) = 0.52

95% confidence interval for
1

| :

{
1

| 1.96 SE(
1

| )} = {2.28 1.96 0.52}

= (3.30, 1.26)

The following two statements are equivalent (why?)
- The 95% confidence interval does not include zero;
- The hypothesis |
1
= 0 is rejected at the 5% level

14
A concise (and conventional) way to
report regressions:
Put standard errors in parentheses below the estimated
coefficients to which they apply.
TestScore

= 698.9 2.28STR, R
2
= .05, SER = 18.6
(10.4) (0.52)
This expression gives a lot of information
- The estimated regression line is
TestScore

= 698.9 2.28STR
- The standard error of
0

| is 10.4
- The standard error of
1

| is 0.52
- The R
2
is .05; the standard error of the regression is 18.6

15
OLS regression: reading STATA
output
regress testscr str, robust

Regression with robust standard errors Number of obs = 420
F( 1, 418) = 19.26
Prob > F = 0.0000
R-squared = 0.0512
Root MSE = 18.581
-------------------------------------------------------------------------
| Robust
testscr | Coef. Std. Err. t P>|t| [95% Conf. Interval]
--------+----------------------------------------------------------------
str | -2.279808 .5194892 -4.38 0.000 -3.300945 -1.258671
_cons | 698.933 10.36436 67.44 0.000 678.5602 719.3057
-------------------------------------------------------------------------
so:

TestScore

= 698.9 2.28STR, , R
2
= .05, SER = 18.6
(10.4) (0.52)
t (|
1
= 0) = 4.38, p-value = 0.000 (2-sided)
95% 2-sided conf. interval for |
1
is (3.30, 1.26)

16
Summary of Statistical Inference
about |
0
and |
1
:
Estimation:
- OLS estimators
0

| and
1

|
-
0

| and
1

| have approximately normal sampling distributions

in large samples
Testing:
- H
0
: |
1
= |
1,0
v. |
1
= |
1,0
(|
1,0
is the value of |
1
under H
0
)
- t = (
1

| |
1,0
)/SE(
1

| )
- p-value = area under standard normal outside t
act
(large n)
Confidence Intervals:
- 95% confidence interval for |
1
is {
1

| 1.96 SE(
1

| )}
- This is the set of |
1
that is not rejected at the 5% level
- The 95% CI contains the true |
1
in 95% of all samples.

17
Regression when X is Binary
(Section 5.3)
Sometimes a regressor is binary:
- X = 1 if small class size, = 0 if not
- X = 1 if female, = 0 if male
- X = 1 if treated (experimental drug), = 0 if not

Binary regressors are sometimes called dummy variables.

So far, |
1
has been called a slope, but that doesnt make sense
if X is binary.

How do we interpret regression with a binary regressor?

18
Interpreting regressions with a
binary regressor
Y
i
= |
0
+ |
1
X
i
+ u
i
, where X is binary (X
i
= 0 or 1):
When X
i
= 0, Y
i
= |
0
+ u
i

- the mean of Y
i
is |
0

- that is, E(Y
i
|X
i
=0) = |
0

When X
i
= 1, Y
i
= |
0
+ |
1
+ u
i

- the mean of Y
i
is |
0
+ |
1

- that is, E(Y
i
|X
i
=1) = |
0
+ |
1

so:
|
1
= E(Y
i
|X
i
=1) E(Y
i
|X
i
=0)
= population difference in group means

19
Example: Let D
i
=
1 if 20
0 if 20
i
i
STR
STR
s

>

OLS regression: TestScore

= 650.0 + 7.4D
(1.3) (1.8)
Tabulation of group means:
Class Size Average score (Y ) Std. dev. (s
Y
) N
Small (STR > 20) 657.4 19.4 238
Large (STR 20) 650.0 17.9 182

Difference in means:
small large
Y Y = 657.4 650.0 = 7.4
Standard error: SE =
2 2
s l
s l
s s
n n
+ =
2 2
19.4 17.9
238 182
+ = 1.8

20
Summary: regression when X
i
is
binary (0/1)
Y
i
= |
0
+ |
1
X
i
+ u
i

- |
0
= mean of Y when X = 0
- |
0
+ |
1
= mean of Y when X = 1
- |
1
= difference in group means, X =1 minus X = 0
- SE(
1

| ) has the usual interpretation

- t-statistics, confidence intervals constructed as usual
- This is another way (an easy way) to do difference-in-means
analysis
- The regression formulation is especially useful when we have
additional regressors (as we will very soon)

21
Heteroskedasticity and Homoskedasticity,
and Homoskedasticity-Only Standard Errors
(Section 5.4)
- What?
- Consequences of homoskedasticity
- Implication for computing standard errors

What do these two terms mean?
If var(u|X=x) is constant that is, if the variance of the
conditional distribution of u given X does not depend on X
then u is said to be homoskedastic. Otherwise, u is
heteroskedastic.

22
Example: hetero/homoskedasticity in the case of a binary
regressor (that is, the comparison of means)
- Standard error when group variances are unequal:
SE =
2 2
s l
s l
s s
n n
+
- Standard error when group variances are equal:
SE =
1 1
p
s l
s
n n
+
where
2
p
s =
2 2
( 1) ( 1)
2
s s l l
s l
n s n s
n n
+
+
(SW, Sect 3.6)
s
p
= pooled estimator of o
2
when
2
l
o =
2
s
o
- Equal group variances = homoskedasticity
- Unequal group variances = heteroskedasticity

23
Homoskedasticity in a picture:
- E(u|X=x) = 0 (u satisfies Least Squares Assumption #1)
- The variance of u does not depend on x

24
Heteroskedasticity in a picture:
- E(u|X=x) = 0 (u satisfies Least Squares Assumption #1)
- The variance of u does depends on x: u is heteroskedastic.

25
A real-data example from labor economics:
average hourly earnings vs. years of education
(data source: Current Population Survey):
Heteroskedastic or homoskedastic?
26
The class size data:
Heteroskedastic or homoskedastic?
27
So far we have (without saying so) assumed
that u might be heteroskedastic.
Recall the three least squares assumptions:
1. E(u|X = x) = 0
2. (X
i
,Y
i
), i =1,,n, are i.i.d.
3. Large outliers are rare

Heteroskedasticity and homoskedasticity concern var(u|X=x).
Because we have not explicitly assumed homoskedastic errors,
we have implicitly allowed for heteroskedasticity.

28
What if the errors are in fact homoskedastic?
- You can prove that OLS has the lowest variance among
estimators that are linear in Y a result called the Gauss-
Markov theorem that we will return to shortly.
- The formula for the variance of
1

| and the OLS standard

error simplifies (pp. 4.4): If var(u
i
|X
i
=x) =
2
u
o , then
var(
1

| ) =
2 2
var[( ) ]
( )
i x i
X
X u
n

o

=
2 2
2 2
[( ) ]
( )
i x i
X
E X u
n

o

=
2
2
u
X
n
o
o

Note: var(
1

| ) is inversely proportional to var(X): more

spread in X means more information about
1

| - we discussed
this earlier but it is clearer from this formula.

29
- Along with this homoskedasticity-only formula for the
variance of
1

| , we have homoskedasticity-only standard

errors:
Homoskedasticity-only standard error formula:

SE(
1

| ) =
2
1
2
1
1

1
2
1
( )
n
i
i
n
i
i
u
n
n
X X
n
=
=

.

Some people (e.g. Excel programmers) find the
homoskedasticity-only formula simpler.

30
We now have two formulas for
standard errors for
1

|
- Homoskedasticity-only standard errors these are valid only
if the errors are homoskedastic.
- The usual standard errors to differentiate the two, it is
conventional to call these heteroskedasticity robust
standard errors, because they are valid whether or not the
errors are heteroskedastic.
- The main advantage of the homoskedasticity-only standard
errors is that the formula is simpler. But the disadvantage is
that the formula is only correct in general if the errors are
homoskedastic.

31
Practical implications
- The homoskedasticity-only formula for the standard error of
1

| and the heteroskedasticity-robust formula differ so in

general, you get different standard errors using the different
formulas.
- Homoskedasticity-only standard errors are the default setting
in regression software sometimes the only setting (e.g.
Excel). To get the general heteroskedasticity-robust
standard errors you must override the default.
If you dont override the default and there is in fact
heteroskedasticity, your standard errors (and wrong t-
statistics and confidence intervals) will be wrong typically,
homoskedasticity-only SEs are too small.
32
Heteroskedasticity-robust standard
errors in STATA
regress testscr str, robust

Regression with robust standard errors Number of obs = 420
F( 1, 418) = 19.26
Prob > F = 0.0000
R-squared = 0.0512
Root MSE = 18.581
-------------------------------------------------------------------------
| Robust
testscr | Coef. Std. Err. t P>|t| [95% Conf. Interval]
--------+----------------------------------------------------------------
str | -2.279808 .5194892 -4.39 0.000 -3.300945 -1.258671
_cons | 698.933 10.36436 67.44 0.000 678.5602 719.3057
-------------------------------------------------------------------------

- If you use the , robust option, STATA computes
heteroskedasticity-robust standard errors
- Otherwise, STATA computes homoskedasticity-only
standard errors

33
The bottom line:
- If the errors are either homoskedastic or heteroskedastic and
you use heteroskedastic-robust standard errors, you are OK
- If the errors are heteroskedastic and you use the
homoskedasticity-only formula for standard errors, your
standard errors will be wrong (the homoskedasticity-only
estimator of the variance of
1

| is inconsistent if there is
heteroskedasticity).
- The two formulas coincide (when n is large) in the special
case of homoskedasticity
- So, you should always use heteroskedasticity-robust standard
errors.

34
Some Additional Theoretical
Foundations of OLS (Section 5.5)
We have already learned a very great deal about OLS: OLS is
unbiased and consistent; we have a formula for
heteroskedasticity-robust standard errors; and we can construct
confidence intervals and test statistics.

Also, a very good reason to use OLS is that everyone else
does so by using it, others will understand what you are doing.
In effect, OLS is the language of regression analysis, and if you
use a different estimator, you will be speaking a different
language.

35
Still, some of you may have further questions:
- Is this really a good reason to use OLS? Arent there other
estimators that might be better in particular, ones that might
have a smaller variance?
- Also, what ever happened to our old friend, the Student t
distribution?

So we will now answer these questions but to do so we will
need to make some stronger assumptions than the three least
squares assumptions already presented.

36
The Extended Least Squares
Assumptions
These consist of the three LS assumptions, plus two more:
1. E(u|X = x) = 0.
2. (X
i
,Y
i
), i =1,,n, are i.i.d.
3. Large outliers are rare (E(Y
4
) < , E(X
4
) < ).
4. u is homoskedastic
5. u is distributed N(0,o
2
)
- Assumptions 4 and 5 are more restrictive so they apply to
fewer cases in practice. However, if you make these
assumptions, then certain mathematical calculations simplify
and you can prove strong results results that hold if these
additional assumptions are true.
- We start with a discussion of the efficiency of OLS

37
Efficiency of OLS, part I: The
Gauss-Markov Theorem
Under extended LS assumptions 1-4 (the basic three, plus
homoskedasticity),
1

| has the smallest variance among all linear

estimators (estimators that are linear functions of Y
1
,, Y
n
).
This is the Gauss-Markov theorem.

Comments
- The GM theorem is proven in SW Appendix 5.2

38
The Gauss-Markov Theorem, ctd.
-
1

|

is a linear estimator, that is, it can be written as a linear
function of Y
1
,, Y
n
:
1

| |
1
=
1
2
1
( )
( )
n
i i
i
n
i
i
X X u
X X
=
=

=
1
1
n
i i
i
wu
n
=

,
where w
i
=
2
1
( )
1
( )
i
n
i
i
X X
X X
n
=

.
- The G-M theorem says that among all possible choices of {w
i
},
the OLS weights yield the smallest var(
1

| )

39
Efficiency of OLS, part II:
- Under all five extended LS assumptions including normally
distributed errors
1

| has the smallest variance of all

consistent estimators (linear or nonlinear functions of
Y
1
,,Y
n
), as n .
- This is a pretty amazing result it says that, if (in addition to
LSA 1-3) the errors are homoskedastic and normally
distributed, then OLS is a better choice than any other
consistent estimator. And because an estimator that isnt
consistent is a poor choice, this says that OLS really is the best
you can do if all five extended LS assumptions hold. (The
proof of this result is beyond the scope of this course and isnt
in SW it is typically done in graduate courses.)

40
Some not-so-good thing about OLS
The foregoing results are impressive, but these results and the
OLS estimator have important limitations.

1. The GM theorem really isnt that compelling:
- The condition of homoskedasticity often doesnt hold
(homoskedasticity is special)
- The result is only for linear estimators only a small
subset of estimators (more on this in a moment)

2. The strongest optimality result (part II above) requires
homoskedastic normal errors not plausible in applications
(think about the hourly earnings data!)

41
Limitations of OLS, ctd.
3. OLS is more sensitive to outliers than some other estimators.
In the case of estimating the population mean, if there are big
outliers, then the median is preferred to the mean because the
median is less sensitive to outliers it has a smaller variance
than OLS when there are outliers. Similarly, in regression,
OLS can be sensitive to outliers, and if there are big outliers
other estimators can be more efficient (have a smaller
variance). One such estimator is the least absolute deviations
(LAD) estimator:
0 1
, 0 1
1
min ( )
n
b b i i
i
Y b b X
=
+

In virtually all applied regression analysis, OLS is used and
that is what we will do in this course too.

42
Inference if u is Homoskedastic and
Normal: the Student t Distribution
(Section 5.6)
Recall the five extended LS assumptions:
1. E(u|X = x) = 0.
2. (X
i
,Y
i
), i =1,,n, are i.i.d.
3. Large outliers are rare (E(Y
4
) < , E(X
4
) < ).
4. u is homoskedastic
5. u is distributed N(0,o
2
)

If all five assumptions hold, then:
-
0

| and
1

| are normally distributed for all n (!)

- the t-statistic has a Student t distribution with n 2 degrees of
freedom this holds exactly for all n (!)

43
Normality of the sampling distribution of
1

| under 15:
1

| |
1
=
1
2
1
( )
( )
n
i i
i
n
i
i
X X u
X X
=
=

=
1
1
n
i i
i
wu
n
=

, where w
i
=
2
1
( )
1
( )
i
n
i
i
X X
X X
n
=

.
What is the distribution of a weighted average of normals?
Under assumptions 1 5:
1

| |
1
~
2 2
2
1
1
0,
n
i u
i
N w
n
o
=
| |
| |
|
|
\ .
\ .

(*)
Substituting w
i
into (*) yields the homoskedasticity-only
variance formula.

44
In addition, under assumptions 1 5, under the null hypothesis
the t statistic has a Student t distribution with n 2 degrees of
freedom
- Why n 2? because we estimated 2 parameters, |
0
and |
1

- For n < 30, the t critical values can be a fair bit larger than the
N(0,1) critical values
- For n > 50 or so, the difference in t
n2
and N(0,1) distributions
is negligible. Recall the Student t table:

degrees of freedom 5% t-distribution critical value
10 2.23
20 2.09
30 2.04
60 2.00

1.96

45
Practical implication:
- If n < 50 and you really believe that, for your application, u is
homoskedastic and normally distributed, then use the t
n2

instead of the N(0,1) critical values for hypothesis tests and
confidence intervals.
- In most econometric applications, there is no reason to believe
that u is homoskedastic and normal usually, there is good
reason to believe that neither assumption holds.
- Fortunately, in modern applications, n > 50, so we can rely on
the large-n results presented earlier, based on the CLT, to
perform hypothesis tests and construct confidence intervals
using the large-n normal approximation.

46
Summary and Assessment
(Section 5.7)
- The initial policy question:
Suppose new teachers are hired so the student-teacher
ratio falls by one student per class. What is the effect
of this policy intervention (treatment) on test scores?
- Does our regression analysis answer this convincingly?
- Not really districts with low STR tend to be ones with
lots of other resources and higher income families,
which provide kids with more learning opportunities
outside schoolthis suggests that corr(u
i
, STR
i
) > 0, so
E(u
i
|X
i
)= 0.
- So, we have omitted some factors, or variables, from our
analysis, and this has biased our results.